"Creative Accounting" Makes Fed Insolvency Impossible

To all who thought that the FASB gives leeway only to banks when fudging their numbers, and boosting their equity capital in ways previously unheard of, we have a surprise. The latest entrant in the "accounting gimmickry" club is none other than the Fed. And since the Fed is not auditable by anyone, it gives itself permission to change and bend the rules in any way it desires. Following on recent speculation that the Fed could in theory have a equity capital deficiency due to its massive asset book, and its tiny equity buffer, both discussed many times previously on Zero Hedge (here and here), the Fed recently announced as part of its January 6 H.4.1 release "an important accounting policy change with the release of its weekly H.4.1 report on January 6 that effectively prevents it from facing a negative capital position even in the event that it incurs substantial losses." Here is how Bank of America's Priya Misra explains this curious, and most certainly politically-motivated development: "The Fed remits most of its net earnings on a weekly basis. Prior to this accounting change, any unremitted earnings due to the Treasury would accrue in the "Other capital" account, but will now be shown in a separate liability line item called "Interest on Federal Reserve notes due to the Treasury.” As a result, any future losses the Fed may incur will now show up as a negative liability (negative interest due to Treasury) as opposed to a reduction in Fed capital, thereby making a negative capital situation technically impossible regardless of the size of the Fed’s balance sheet or how the FOMC chooses to tighten policy." And there you have it: instead of reducing the left side of the balance sheet upon the incurrence of losses, the Fed has decided to fudge the right side. And presto. No more possibility of insolvency ever again. Which only means that the Fed's now ridiculous DV01 of just under $2 billion will in no way prevent the world's biggest hedge fund from taking proactive steps to actually mitigate rate risk, and in fact will likely encourage it to gamble even more with taxpayer capital.

More from Bank of America:

Accounting change prevents a Fed “insolvency” scenario

Mounting concerns about Fed “insolvency” post QE2

The Fed announced an important accounting policy change with the release of its weekly H.4.1 report on January 6 that effectively prevents it from facing a negative capital position even in the event that it incurs substantial losses. The timing of the change is not coincidental, as politicians and market participants alike have expressed concerns since the announcement of QE2 about the possibility of Fed “insolvency” in a scenario where interest rates rise significantly. These concerns have prompted some observers to suggest that the Fed may be unable to tighten policy sufficiently once the economy recovers, since doing so could result in a negative capital situation and the need for a Treasury “recapitalization,” thereby compromising the Fed’s political independence.

Fed required to remit profits to Treasury (not build capital)

Since 1947, the Board of Governors has required that the Reserve Banks remit nearly all net earnings to Treasury. Remittances are roughly equal to income from loans and securities holdings less operating expenses, interest paid on depository institutions’ reserve balances, dividends paid to member banks, and any amount necessary to top up the Fed’s capital. Fed remittances have surged since late 2008, reflecting its aggressive balance sheet expansion in the context of nearzero term interest rates (Chart 1). The Fed could potentially incur losses, however, if short term rates rose such that the interest paid on bank reserves exceeded the interest income of the System Open Market Account, or SOMA portfolio. Similarly, the Fed could face capital losses if it were to sell securities below their original purchase price (Chart 2). Note that the SOMA portfolio is not marked to market, but is reported on a par-value basis each week, so higher yields would only impact Fed earnings in the context of asset sales.

Accounting change prevents negative Fed capital situation

The Fed remits most of its net earnings on a weekly basis. Prior to this accounting change, any unremitted earnings due to the Treasury would accrue in the "Other capital" account, but will now be shown in a separate liability line item called "Interest on Federal Reserve notes due to the Treasury.” As a result, any future losses the Fed may incur will now show up as a negative liability (negative interest due to Treasury) as opposed to a reduction in Fed capital, thereby making a negative capital situation technically impossible regardless of the size of the Fed’s balance sheet or how the FOMC chooses to tighten policy. There will be no change to the current practice of remitting profits to the Treasury on a weekly basis, but the Fed will postpone any remittances if this line item becomes negative. In effect, any losses will be offset against future Fed remittances to the Treasury. In our view, this policy appears to be a clever solution to the Fed’s inability to provision for potential future losses by retaining earnings today. We expect it to mitigate – though not fully allay – concerns about Fed solvency.

The Board's H.4.1 statistical release, "Factors Affecting Reserve Balances of Depository Institutions and Condition Statement of Federal Reserve Banks," has been modified to reflect an accounting policy change that will result in a more transparent presentation of each Federal Reserve Bank's capital accounts and distribution of residual earnings to the U.S. Treasury. Although the accounting policy change does not affect the amount of residual earnings that the Federal Reserve Banks distribute to the U.S. Treasury, it may affect the timing of the distributions. Consistent with long-standing policy of the Board of Governors, the residual earnings of each Federal Reserve Bank, after providing for the costs of operations, payment of dividends, and the amount necessary to equate surplus with capital paid-in, are distributed weekly to the U.S. Treasury. The distribution of residual earnings to the U.S. Treasury is made in accordance with the Board of Governor's authority to levy an interest charge on the Federal Reserve Banks based on the amount of each Federal Reserve Bank's outstanding Federal Reserve notes.

Effective January 1, 2011, as a result of the accounting policy change, on a daily basis each Federal Reserve Bank will adjust the balance in its surplus account to equate surplus with capital paid-in and, in addition, will adjust its liability for the distribution of residual earnings to the U.S. Treasury. Previously these adjustments were made only at year-end. Adjusting the surplus account balance and the liability for the distribution of residual earnings to the U.S. Treasury is consistent with the existing requirement for daily accrual of many other items that appear in the Board's H.4.1 statistical release. The liability for the distribution of residual earnings to the U.S. Treasury will be reported as "Interest on Federal Reserve notes due to U.S. Treasury" on table 10. Previously, the amount necessary to equate surplus with capital paid-in and the amount of the liability for the distribution of residual earnings to the U.S. Treasury were included in "Other capital accounts" in table 9 and in "Other capital" in table 10.